INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Investment Basics: Inflation Its Causes and Impacts

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1 INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Investment Basics: Inflation Its Causes and Impacts By Joseph N. Stevens, CFA Area Assistant Vice President PoliticalCartoons.com Anyone driving a vehicle for some period in the past decade likely has personally experienced the painful increase of prices at the gas pump. For the 10 year period from , the average price of unleaded gas in the United States increased 221% from $1.59 to $3.53, based on data from the U.S. Department of Labor. A price increase such as this is referred to as inflation, a phenomenon that has occurred at different times throughout history, from the hyperinflationary period in Germany in the 1920s to the United States in the 1970s. While the topic of inflation garners much attention from the media and general public, what exactly are some of the causes of inflation, and what is its impact on the economy and financial assets? 1 AJG.COM

2 Causes One cause of inflation is imbalances between the supply and demand for certain products. Changes in the price of unleaded fuel, for instance, are closely related to changes in the worldwide supply and demand for crude oil, since unleaded fuel is a byproduct of crude oil. Higher gas prices can occur from factors that increase demand for oil, such as population growth or from supply shocks that limit oil production or transmission such as instability in the Middle East or hurricanes in the Gulf of Mexico. Alternatively, oil prices can be held in check by rising supplies, such as those resulting from the increased use of hydraulic fracturing techniques that enhance the output of oil wells. A particularly troublesome aspect of inflation caused by productspecific demand and supply shocks is that it can be spread, as in the example of companies passing increased energy costs on to their customers by raising prices of their own products or services. Another common cause of inflation is currency depreciation, which occurs when one currency becomes less valuable in terms of another. For example, if the dollar depreciates relative to the Japanese Yen, more dollars are required to acquire the same product in Yen. Another common cause of inflation is currency depreciation, which occurs when one currency becomes less valuable in terms of another. A company that utilizes foreign markets as part of its supply chain is affected by this exchange, which may lead the company to pass on some, if not all, of the higher costs to its customers. In some cases an increase in the money supply itself can lead to inflation, a theory supported by Nobel Prize-winning economist Milton Freidman, who illustrated this point with a hypothetical story in which a helicopter drops money onto an island. In this example, the increase in the money supply would lead to more money chasing the same amount of goods, thus driving up the prices of those goods. The theory, importantly, relies on two assumptions: that people s willingness to hold money is constant, and that the economy is operating at full capacity. In practice, the amount of money people wish to hold and the strength of the economy vary significantly, and thus an increase in the money supply may not always be inflationary. Accordingly, an increase in the money supply is more likely to be inflationary when the economy is operating at full employment and capacity and people are ready to hold less money. 2 AJG.COM

3 Impacts Higher rates of inflation can be particularly damaging to investment assets that generate fixed cash flows, such as bonds, since the amount of cash flow does not increase despite rising prices elsewhere. The value of financial assets can also be affected by inflation because of how assets are valued. For instance, a common technique used to value an asset is to discount the asset s projected future cash flows at an interest rate that compensates an investor for liquidity, credit, interest rate and inflation risk. All things equal, as investors expectations for inflation increase they require higher interest rates to compensate them for the additional risk; as such, discounting an asset s future cash flows at a higher interest rate results in a lower price for that asset. Asset prices can also be affected if cash flows are reduced by inflation, such as the case when businesses face higher costs for raw materials. If that business is unable to pass along those higher costs to its customers, it will experience lower earnings and thus be less valuable of a business. On the other hand, higher inflation generally will be less damaging to investments where the cash flows vary with inflation or where the price of the asset itself increases along with inflation, such as commodities, infrastructure or real estate. Inflation not only impacts Wall Street, but can create inefficiencies on Main Street. For instance, menu costs refers to the cost firms incur when they continually adjust their products or offerings to account for inflation. This can create an environment of unstable prices, which makes it difficult for customers to efficiently allocate their resources to purchases goods and services, causing detriments to the economy. It also negatively impacts business profits, as organizations often incur costs to continually communicate their price changes. An extreme example of this occurred during the hyperinflationary period of the 1920 s in Germany when it was common for waitresses to stand on tables several times during lunch and shout out new prices. Another significant inefficiency associated with inflation occurs when it is unexpected. If inflation is expected, creditors can increase the interest rate they require to compensate for decreases in future purchasing power. However, when it is unexpected, wealth is redistributed from creditors to debtors as debtors pay back loans with less valuable dollars. If there is considerable uncertainty surrounding inflation, creditors will require higher rates and make fewer loans, which will result in lower real economic growth. 3 AJG.COM

4 Conclusion For twenty years from , inflation represented by the Consumer Price Index ( CPI ) in the United States has rose at a rate of 2.4% per year. As a U.S.-based investor, it s easy to be complacent regarding inflation because it has been benign for so long. However, during the 10 year period from the CPI rose at an annualized rate of 8.6%. As described in this paper, there are a number of factors that can trigger inflation, although forecasting these factors is difficult. Although we may not be able to predict when conditions conducive to inflation will occur, we can say with reasonable certainty that they will. Despite the potential risks and difficulty forecasting inflation, there are still actions investors can take to protect themselves. Investors should ensure their portfolios are hedged against inflation risk by owning assets whose value is expected to vary with inflation, such as commodities and real estate. Although we may not be able to predict when conditions conducive to inflation will occur, we can say with reasonable certainty that they will. 4 AJG.COM

5 About the Team Joseph N. Stevens, Area Assistant Vice President, is part of the Institutional Investment & Fiduciary Services team of Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC ( Gallagher ), focused on improving the investment program of your benefit plan and other investment pools. Gallagher s Institutional Investment & Fiduciary Services team are a group of established, proven investment professionals who provide objective insights, analysis and oversight on asset allocation, investment managers, and investment risks, along with fiduciary responsibility for investment decisions as an independent fiduciary or outsourced CIO. Joseph N. Stevens, CFA Area Assistant Vice President Institutional Investment & Fiduciary Services joseph_stevens@ajg.com Gallagher Fiduciary Advisors, LLC Investment advisory services and named and independent fiduciary services are offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment Adviser. Gallagher Fiduciary Advisors, LLC is a single-member, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Neither Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates provide accounting, legal or tax advice. 5 AJG.COM